Comparing Preferred Equity vs. Debt – for Real Estate Investors

One of the important decisions that investors make with real estate is whether to invest via equity or debt. This post describes key differences between these types of investments, and why iFunding has chosen to specialize in preferred equity financing, which we feel is the most attractive blend of returns and control for many investors.

What is preferred equity vs. debt investing?

First, definitions, which you can skip and go to the comparison, if you’re comfortable with preferred equity and debt investing:

Investing via equity in real estate means that you are a shareholder in a project. The project, be it a home refurbishment, a retail space, or office tower, generates profits through some combination of increase in price between purchase, improvement and sale, or via tenant rental income. You as the equity investor receive a share of the net profits after expenses, and the profits also are shared with the project developer/operator, and the promoter or crowdfunding platform. Many equity investments, including most of those from iFunding, include a “preferred equity” component: from any profits after project costs, the first cut is returned solely to the investors, not to the developer for their work. In the real estate investment sector, preferred equity often is set at 8-10% target return. After preferred equity profits are paid out, the remaining profits typically are shared at 30-50% going to the project’s operating partner, and the remaining amount to the investors (50-70%), with a modest fee going to the crowdfunding platform.

In addition, there are significant financial benefits to equity investing in that when property depreciates, investors can participate in the on-paper losses to offset other income they have. Also, longer-term profits may be taxed at long-term capital gains rates. We’ll cover these considerations in another post.

Investing via debt means that a loan is provided to the project operator. The investors receive a fixed rate of return. The payback of the loan is usually guaranteed against the property asset itself. That is, this is a mortgage similar to what you’d have on your own home. Instead of directly listing the investor as a lender, however, in crowdfunding the invested money is pooled in an entity such as an LLC and this entity lends the money to the project operator.

How to decide on preferred equity vs. debt investing?

  • Returns: Typical returns on equity investment in real estate can range from 18% to 40%, annualized, or more. Typical interest rates on debt, or lending, currently range from 8% to 13%, annualized, in the crowdfunding business.
  • Principal: With equity, investors participate in the profit or loss on the project, much like stock you hold can go up or down in value. The investor would want to be comfortable with this dynamic. Real estate debt is generally considered somewhat safer, as it behaves similarly to high-yield corporate debt. Principal is intended to be repaid regardless of project profits, but there are situations in which a borrower may default and foreclosure proceedings occur over the assets.
  • Investment duration and payment frequency: Equity investments and debt both are available with short term returns, such as house refurbishments completed in a few months, and on longer term holds, usually commercial property spent with rental and upgrade potential. Profits returned on equity investments often tend to be paid out quarterly or annually and with a significant lump sum at the end (sale) of the project. Interest on debt usually is paid quarterly or monthly, sometimes annually, in the crowdfunding world, again with a lump sum return of capital at the end of the loan.

Questions to Ask Crowdfunders

While equity and debt are relatively straightforward to understand, there are nuances, especially in the crowdfunding world, that you’ll want to ask your fundraising platform about:

If equity:

  • How much oversight and control does the crowdfunding platform have over each project? If the project is sidetracked for any reason, what ability does the crowdfunding platform have to identify the issue and direct it’s resolution? At iFunding, our company serves as the manager of the entity overseeing the project. iFunding holds title over the property in nearly every case, so the property itself is part of the guaranty underlying investors’ principal.
  • Is the investment individually structured for protection? investors should prefer that the property title and their funds are held in a corporate entity set up solely for the purposes of the one project. That is, any financial issues with other projects or with the crowdfunding company itself should not affect the ownership, liens on, or reliability of a particular investment. iFunding structures its offerings this way, through “single purpose entities,” which continue as viable, legally-protected entities regardless of the status of other investments or the company itself. iFunding does not create a more complicated structure, with the property/project in one LLC, and the financing in another LLC that invests in the first. Other crowdfunding sites have taken this two-tier approach, however unwinding them or otherwise following the property ownership and lien structure (should that be required on a difficult project) can be more complex .
  • What’s the term of the investment? Equity investment durations can range from a few months to several years on the crowdfunding sites. Different durations will interest different investors. Be aware that longer term investments, such as larger commercial properties, can both be more stable, in that existing properties have a demonstrated operating track record of occupancy and cash flow. However, investments that are committed for years are more subject to macro-economic trends which can cause ongoing returns and final value to fluctuate.

If debt:

  • Do the investors have a true guaranty on the property? In some cases, crowdfunders actually give investors a promissory note, which says that the crowdfunding company promises to pay the investor — as long as the project operator first pays the crowdfunding company. It’s the crowdfunding company only that has a guaranty. The investors don’t have direct control over the assets should investor repayments stop and the property needs to be foreclosed. But, how aggressively will the crowdfunding site pursue foreclosure and return of investor’s money?
  • What happens if the crowdfunding company is no longer available to make payments, is unable to make timely payments, or closes itself? Have the site explain their backup processing plan if they are no longer in business, and confirm whether the switchover to the backup plan is automatic, or depends on the crowdfunder being involved to take action. In these two preceding situations, the security of debt investing may be less than in traditional real estate lending, where the investors have direct property title or borrower guaranty.
  • Your ultimate return on real estate debt also depends on how long the interest accrues. If a project, like a home refurbishment, is completed and sold ahead of schedule, a loan that you thought would yield interest for a year may only provide interest for a few months. If so, you’re actual return after taking the time to research and invest in the project (and cost of a wire of funds), may be just a few percent. At a minimum, ask the crowdfunding site whether pre-payment (early loan completion) premiums are paid by the real estate operator and passed back to the investors in this case. Also, calculate your likely absolute return as well as an annualized rate.

The Case for iFunding and Preferred Equity

Experts recommend that sound investing involve diversification of your portfolio, both across asset classes such stocks, bonds and real estate, and within a class, that is, different property types, locations, investment durations, and equity vs. debt structure. So there’s certainly room, and benefit, to hold a variety of investment types and hold both equity and debt. iFunding offers both but specializes in preferred equity.

Our investors tell us that, the more comfortable they become with real estate, the more they appreciate the combination of potential returns and control that iFunding can offer through preferred equity deals. We offer a range of property types across the nation, with many being shorter-term, smaller budget equity investments. A “preferred equity” component means that the first distribution of profits goes to the investors, putting individuals like yourself on par with what financial institutions traditionally have received in equity investment terms. Finally, we believe we lead the industry in oversight of project and frequency/detail of reporting on project activity, increase the quality of project and investment results and increasing your comfort about investment status.

Read a step-by-step explanation of the iFunding investment process here.